The social cost of carbon in one equation

Climate economics is a hugely complex undertaking, especially if you want to get some quantitative answers. Indeed, one has to embed economic and climate models into each other, and the later are not simple particularly once you want to incorporate the impact of some additional pollutants that bring the model outside of historical records. This complexity makes is largely impossible for most of us to attempt at looking at, say, at the effect of our favorite policy intervention.

This need not be so, write Inge van den Bijgaart, Reyer Gerlagh, Luuk Korsten and Matti Liski. Indeed, they find that one can reduce these complex interactions to a single equation and get it 99% right when trying to calculate the social cost of carbon (the monetary equivalent of carbon in the air). While the equation is not particularly simple, it is useful in the sense that one still needs to explicit one's assumptions when using it. And unlike a fundamental equation recently discussed here, the authors detail how it is derived.

When generations disagree on the environment

Many ecosystems feature thresholds beyond which they tip over, in some cases irremediably. The dynamics are, however, so complex that it is sometimes anybody's guess where this threshold is. But this can be dealt with in an infinite-horizon model, and an optimal schedule of, say, pollution can be determined.

Thomas Michielsen shows, however, that this breaks down once you consider successive generations, as in some sense they disagree on the discount rate. Any generation is willing to have a little more pollution and have future generations bear the cost of either reducing pollution or the risk of the ecological catastrophe. And this time inconsistency leads to an increase of the likelihood of the tipping point happening earlier. How can you prevent this? Michielsen suggests to keep the stock of pollution at its current level, as it is known to be safe. That seems drastic. I would prefer to keep pollution at the dynastic model outcome, but it is indeed difficult to see how generations could commit to such levels.

PS: FEEM needs to stop immediately with these multicolored abstracts. They are absolutely horrible.

Strict environmental policy through tax competition

Tax competition is a double-edged sword: it keeps government on their toes regarding their expenses, but it also saps their ability to provide public goods. Generally, you would want some level of cooperation across authorities, like in a cartel, as pure tax competition is not believed to reach optimal outcomes. This is particularly true with environmental regulation and taxation.

Cees Withagen and Alex Halsema claim that tax competition may lead to a first best in an environment with cross-border pollution. The important word here is "may" as it still needs to be established that it can happen in practice. The innovation to their approach is to include endogenous capital to the model: capital can flee to other jurisdictions if it is taxed too high. Governments then play against each other. This pushes them to keep capital tax rates low. With more capital and income, demand for environmental quality is higher and emission tax rates are higher. With some luck, the latter may get exactly at the first best. It all depends on the environmental demand parameters, which are hard to estimate, though. A good opportunity to find some better measurements.

Greening the tax system works

It has been some time that I have not mentioned the virtues of greening the tax system. By that I mean levying taxes on activities that exert negative externalities on others, such as pollution or congestion, while reducing standard taxes such as the income tax and even subsidizing activities that have a positive externality, such as getting educated. Yet, despite that great virtues of greening the tax system, it happens only moderately. Maybe it is because it bears some short-term costs before yielding longer term benefits.

Walid Oueslati confirms this using an endogenous growth model. In the long run, growth and welfare are indeed enhanced by environmental taxes if the proceeds are used to reduce wages taxes (but not capital taxes, a surprise given the optimal capital tax literature). In the short run, however, the impact on both can be negative due to the reallocation of factors during the transition to the new steady state. These disruption are similar to the sort-term costs of freeing up international trade. If you add it some temporary transfers to those who suffer in the transition, all is good and current opponents trying to protect some rents should be willing to go along. So, what are we waiting for?

PS: This must be the worst-looking working paper cover I have seen so far. The abstract is unreadable. Why this choice of colors?

How much did the Gulf Oil Spill cost to shrimp consumers?

When the Deepwater Horizon oil platform exploded in 2010 and polluted much of the Gulf of Mexico Coast, some of the loudest complaints came for shrimpers fearing rightfully for their livelihood. The subsequent debate on how much the polluters should pay has been in part fueled by the question of how high the economic costs of the spill are, with a focus on repairing the pollution on the coast and in the water, as well as the economic costs to those living in the area. Ignored in all of this are damages to people outside of the region, for example shrimp consumers.

Addison Ellis, Jaclyn Kropp and Michael Norton identify for this case three sources of damages: higher prices, substitution to less liked goods, and added stigma from consuming Gulf shrimp (because it was perceived to be more risky). For the two first, they estimate the loss of consumer surplus to about US$100 million. For the third, they performed a series of experiments in 2010 to elicit from participants their willingness to pay for various types of shrimps. The stigma is reflected in a willingness to pay US$1.10 less per half-pound for Gulf shrimp. In terms of overall cost, my calculation indicates this would increased it by a little less than US$400 million, as 80,000 metric tons of shrimp were produced in the Gulf in 2010 (note the spill occurred on the 10th of April). Not small potatoes.

Discounting for future generations: the consensus?

I have discussed a few times the difficulty of figuring out what the proper discount rate should be when evaluating the impact of environmental policy, and in particular how small changes in that rate can have a huge impact on outcomes. See posts I, II, III, IV. And if there is so much disagreement and this matters so much, why not convene all the arguers and get them to agree on a common document?

This is what the US Environmental Protection Agency did , and the resulting document is co-signed by Kenneth Arrow, Maureen Cropper, Christian Gollier, Ben Groom, Geoffrey Heal, Richard Newell, William Nordhaus, Robert Pindyck, William Pizer, Paul Portney, Thomas Sterner, Richard Tol and Martin Weitzman (no Nicholas Stern, I note). They agree that the proper tool to determine the discount rate is the Ramsey formula. No big surprise here. They agree that a crucial component of this formula is the expected future growth rate of the economy, and that this is very difficult to obtain. And this is as far as they got. No magic number, after all they are economists. I wonder whether biologists could now be convinced that we actually need a discount rate.

When restricting access to financial markets is good

In standard economic theory, any friction that inhibits the clearing of markets or efficient allocations is viewed as bad, and so it should. But there may be some situations where adding frictions leads to better outcomes. One example is the Tobin tax of financial transactions which is thought to prevent excessive speculation and volatility.

Aleksander Berentsen, Samuel Huber and Alessandro Marchesiani have come up with another potentially useful friction. Imagine a world where economic agents face individual and aggregate shocks to liquidity, and there are liquid (money) and illiquid asset markets. Of course, they will want to use these assets to insure themselves against these fluctuations. One way is to accumulate liquid assets yourself. Another is to acquire them from others when needed. But because the latter option is easily available, there is not enough aggregate liquidity as its price is too low: people do not factor in the positive externality on markets of getting more liquidity. The authors argue that this effect can be so strong that it is worthwhile curtailing financial markets so that agent accumulate more liquidity for themselves (and others).

The unemployed should shop less for bargains, and they would not be unemployed

It sucks being unemployed. You have a significant loss in income and your self-esteem takes a hit, for example. However, you enjoy significantly more leisure time (as mentioned earlier, job search takes on average a ridiculously small amount of time). That leaves unemployed people also with plenty of time to do bargain shopping.

Greg Kaplan and Guido Menzio remind us that this negative externality also works the other way: when a company hires someone from the pool of unemployed, this person does less bargain shopping and increases the profits of other companies. Kaplan and Menzio manage to measure these externalities and argue they are strong enough to generate strategic complementarities that can trigger self-fulfilling equilibria. And in such case, expectations become very important. Another reason why I think it was a very bad idea for Paulson and Bernanke to publicly hit the panic button in 2008 (see I, II).

Sin taxes and liberty

I have discussed quite a few times sin taxes that are instituted to redress some individual behavior. Indeed, people make choices that harm others or themselves directly or indirectly. They create congestion and pollution by driving a care, they increase tax- or insurance-financed health care cost by smoking or becoming obese, they also become public hazards by being drunk. This is one reason why we often tax automotive fuels, unhealthy foods, tobacco and alcohol more than other goods.

But some people object to such sin taxes because they infringe on personal liberties. One of them is Gilles Saint-Paul, whose work I have several times discussed here in a positive light (I, II, III), but this time I have to disagree. His view is that the state is too paternalistic when it intervenes in otherwise free markets with sin taxes, and this has become worse since behavioral economics has highlighted choice patterns that deviate from standard utilitarianism. Well, this is exactly the point. Behavioral economics has brought forward that there are situations were people take actions that they later regret. This is precisely when they would appreciate (at least later) some paternalism in the sense that the state can provide them with a commitment device.

So why does Saint-Paul object to this? His argument is that one should not object to personal choices, and that people should only blame themselves for poor choices. But what if one can help them? Should this not happen only because it is the state? He complains that economists have abandoned utilitarism, which maximizes the sum of individual utilities. I do not think that is correct, but he seems to completely ignore that there are externalities out there, that there is regret, that there are temptations, and that there is lack of commitment. and all this should not be myopically ignored when computing utilities. He is going as far as comparing this supposed abandonment of utilitarianism to eugenics. In other words, he sees excessive government intervention. I agree that there is potential for this, but I see no demonstration that this is happening, and the mere fact that there is intervention is not sufficient, as Saint-Paul seems to imply in a rather puzzling paper.

PS: Robert Wiblin at Overcoming Bias has recently made a similar argument to libertarians in favor of paternalism and also finds it "incredibly obvious." Yet, it needs to be made.

Dealing with congestion: fast lane or toll booth?

In densely populated areas, road congestion is a fact of life. As time lost in traffic has an economic value, it is then quite obvious that road pricing with flexible tolls that depend on the current level of demand should provide for the most efficient allocation of cars through time and space. But there are some logistic problems with this, and depending on the actual implementation, some privacy issues as well.

Mogens Fosgerau claims one can get a Pareto improvement with a toll lane that is reserved for particular users if demand is inelastic. The lane set-up is similar to airport check-in, where privileged people get their own lane and others can use it if it is available. I question, though, that demand is inelastic. That may well be the case in the short-run, but people do adapt to road prices on a longer horizon by changing schedules and locations. Also, I find the comparison to tolls unfair in the sense that the benchmark is a coarse toll: there is a single toll price that is only activate when there is congestion. Obviously, it creates peak loads right before and after it is in place. That can easily be improved with more flexible pricing.

What to do about climate change: looking beyond the discount rate controversy

When the Stern Review, which discussed global climate change from an economic perspective, came out, it generated a lot of discussion because of some of the assumptions that were taken. Biologists objected to the use of a discount rate even if it was only 0.1%, and economists William Nordhaus (2%) and Richard Tol (1 to 3%) objected to the value of the discount rate that was chosen. This controversy about the discount rate was reflected in a few posts of mine (I, II, III).

Etienne Espagne, Baptiste Perrissin Fabert, Antonin Pottier, Franck Nadaud and Patrice Dumas point out that the controversy between Nicholas Stern and William Nordhaus goes beyond the discount rate: the choice of the growth rate of technological progress in abatement and the sensitivity of climate to pollution. Using a climate policy model, they show that that changing these two values to their respective extreme values generates about as much variation in results in terms of the social cost of carbon as for the discount rate. But the discount rate cannot explain the differences in policy recommendations between Nordhaus and Stern, while the other two parameters can. We can thus somewhat discount the discount rate controversy and focus more on abatement technology and the climate models.

A discussion of biofuel policies, as seen from Iowa

Biofuels have been presented as the solution to the ills of petroleum: locally produced, renewable, and sometimes cleaner. Hence they have been encouraged by many governments, but some advocates of biofuels now show some remorse. As they are produced from good used for food, biofuels may be responsible for the worldwide increase in food prices. What are then appropriate policies with respect to biofuels?

GianCarlo Moschini, Jingbo Cui and Harvey Lapan, all from Iowa and thus from a state that has been the major beneficiary of biofuel subsidies, write a survey of the Economics of biofuels. They seem to be quite worried about the limits to the expansion of biofuels. Indeed, blending ratios cannot be increased without major technological changes on both the production and user sides, which highlights that path dependence in technological choices is important, and always thinking about the individual explosion engine as a limits the horizon of possibilities. But this is more thinking about the Business of biofuels than the Economics of biofuels. The latter requires much more discussion about whether biofuel subsidies are the best option to reduce carbon emissions (they are not, and carbon taxes are much, much more efficient in this), whether there would be better ways to harness energy from the sun, and how competition with food production (which is much less subsidized, if at all) makes essential food too expensive for the poor. I am happy that even in Iowa, the Economics of biofuels can take precedence over the Business of biofuels.

Taking care of free-riders in global warming policies

By now, global warming (or rather global climate change) seems inescapable, with many, many indicators showing a definite trend towards a rapidly changing environment. Given the large scale of this evolution, it is difficult to believe that a simple trick would stop or even reverse it.

David Martimort and Wilfried Sand-Zantman think they found it: get countries to contribute to a general fund and to reduce pollution, but only the most efficient ones at reducing pollution significantly do it. The design of this mechanism is build to solve a double problem: free-riding in participation and effort. The key is to provide a fixed menu of options to countries. This is allows to separate them according to their heterogeneous preferences and abilities, much like insurance companies separate policy holders by offering a menu of policies. In this case, countries would contribute to a green fund more or less, trading this off against subsidies for pollution reduction that are financed from this green fund. The key is that the non-participation of any country would make the whole agreement fail, thus making everyone willing to pay. That is of course under the assumption that no country would actually benefit from climate change. And that it is not too late.

Voluntary pollution restrictions do not work

The literature on international environmental agreements has established that when such agreement are only of the self-enforcing kind (not imposed by a supranational entity), they cannot exceed three participants. That is certainly disappointing, as we would need much more than that to get significant impact. This literature, however, looked at these countries in a vacuum, in particular the only interaction they would have is through pollution. Now it turns out that in reality they also trade with each other, and trade policy is also available as an instrument.

This is how Thomas Eichner and Rüdiger Pethig expand the extant literature. The addition of trade allows more countries to participate in a self-enforcing agreement. But this comes at the cost of an agreement with significantly less bite. These are interesting results, but I have a hard time finding intuition for this, and the authors are not of much help. Consider this to be an appeal for clarification.

Why is there so little Economics in environmental policy?

A persistent frustration for economists is that policy makers do not listen to them, especially politicians. That they then accuse economists for bad outcomes is then the cherry on top. One area were has been the most evident is in dealing with the environment. Why is it that policy makers (and environmentalists) are reluctant to adopt market-based solutions to environmental issues?

Dallas Burtraw looks at the case of the United States and concludes that this all boils down to politics, and more precisely the federalist institutions. In other words, economists do not take into account the institutional framework where their policies need to fit in, a lament that has also resonated with implementers of development policies. In the case of environmental policy in the US, the issue is mostly that the states have to implement federal policy, and it is much easier to issue emissions caps, compared to coax them to manage honestly cap-and-trade market or collect carbon taxes. For example, consider electricity markets, which are heavily regulated in some states, which means the price signal has less value. Or a state may try to attract industries by circumventing the impact of environmental policies if they are price-based. All-in-all, a political economy of the environment is as much needed as environmental economics.

A negative discount rate for climate policy?

Ever since the Stern Review on climate change came out, the debate has raged about what the appropriate discount rate should be to evaluate future environmental outcomes. Biologists do not see the point of discounting, but they have a biased view as they advocate preservation at any cost (much like doctors advocate preserving every life at any cost). In any case, computing future benefits of something at an infinite horizon is impossible if there is no discounting and the benefits do not decrease.

Marc Fleurbaey and Stéphane Zuber actually advocate that we should use a negative discount rate. Technically, that it is only possible to calculate the net present value with a negative discount rate only if the periodic values decrease at a faster rate than the absolute value of this negative discount rate. The key here is not to think of the discount rate as a fixed number, but rather as a result from the ratio of marginal utility from successive periods (or generations). If future generations are worse off, the discount rate becomes indeed negative. Whether future generations will indeed be worse off is is difficult to ascertain, but it could happen. But this is not how we should think about this.

The proper measurement is to use the marginal utility of the person alleviating today the impact of climate change versus the marginal utility of the person in the future benefiting from this action in the future. This is a person-to-person calculation. The present one is likely rich, the future one likely poor. Thus the discount rate should results from the comparison of these marginal utilities is negative, especially because the developing economies are likely to suffer the most from climate change.

Do we want to curtail internal tax competition?

I mentioned only a couple of days ago that tax credits for economic development do not work. Yet, politicians cannot help it to grant such credits, in part because they want to show they are doing something to help the economy, and in part because they genuinely think it works. And obviously, they do not take into account that other politicians do the same thing, and thus a competition emerges that gives away more and more tax credits for no local gain and certainly no aggregate gain. How could this vicious circle be broken?

Timothy Hubbard and Justin Svec have a proposal. The idea is that these tax credits create a negative externality on other jurisdictions. Thus one could apply the same strategy as for pollution, where a limited number of pollution permits are sold or distributed (the former being the preferred way). Here politicians would have tax credit permits, which they could trade as well. The Federal government would provide these permits and could even determine a socially efficient number of them. Next: name-calling permits for bloggers.

Climate mitigation versus development aid

From what I can see, the countries that are going to suffer the most from climate change are developing ones. As we economists are constantly worried about the efficient use of resources, I am surprised no one asked before whether one should rather invest in mitigating climate change or in improving development aid for those most affected countries.

Lucas Bretschger and Nujin Suphaphiphat try to answer this question with a model where climate change leads to a faster capital depreciation (think: more hurricanes, flooding and tornadoes). The model has two countries, a rich, capital-intensive one and a poor one. The available policies are devoting resources to pollution control or directing transfers to the poor country, which could increase its capital. While the first is obviously better for the rich country, it turns out to be also better for the poor one under fairly general conditions. The reason is that transfers have only a mild effect on growth, whereas this is not-trivial if you can avoid a faster depreciation of capital. Indeed, if you know that your investment will last longer, you will do more of it. The availability of resources for savings and investment is secondary. And that is even without assuming that development aid is not effective, as many believe.

On the distributional effect of environmental taxes

Environmental taxes, as I have often argued on this blog, are an excellent way to raise revenue for the government while taking care of negative externatilites. But as almost any taxes, they are redistributive. In particular if environmental taxes are used to substitute for distorting income taxes, which is good, they may also change redistribution in ways that are not preferred.

Mireille Chiroleu-Assouline and Mouez Fodha admit that environmental taxes are regressive, but this is not a problem. Indeed, they show that it is possible to introduce environmental taxes by making everyone better off. This Pareto improvement comes from lowering average income tax rates with an increase of their progressivity, no matter how regressive environmental taxes are. Interestingly, this result is obtained without even using the environment in the utility of households. In other words, this could also be applied where there are no environmental externalities.

Wind farms: Is NIMBY justified?

Personally, I find wind farms to be beauties. They are very elegant and even in large numbers the wind mills offer a sumptuous spectacle. But not everyone shares this point of view, and especially the windmills' neighbors are railing against their visual impact, their shade and their noise. If it is so bad, it must then have an impact on property values. It turns out that it is actually quite difficult to find a significant effect. So is all this NIMBY talk a big fuss for nothing?

Yasin Sunak and Reinhard Madlener point out that the small literature on the topic uses OLS estimates of hedonic models. That is how property valuation studies are usually done, but they find that results can change if one uses geographically weighted regressions, and one takes into account spatial autocorrelation. The analysis is performed for a particular area of Western Germany. It would have been more convincing if this study would have overturned the results of an earlier one. The study also excludes re-sales, for technical reasons. But of course, one could also concentrate on re-sales to see the impact of the windmill proposal and then its construction. Still, their specification can tease out some interesting results. OLS estimates reveal a negative impact that becomes more complex with a more general specification: the negative impact is much stronger in one city compared to the other, all else equal. Some areas even benefit. It would be interesting to see whether this is from internal migration away from the windmills.